Contango Unchained: How I Learned To Stop Worrying And Love The VIX

I recently wrote an article about the VIX index and associated ETFs. When I started writing the article I had high hopes, but as my research progressed I realized that there are serious problems with the VIX ETFs, they simply don't track the index well at all. Because of the poor tracking error I wrote a warning at the top of the article. Everything I write must be put in the context that these ETFs have serious flaws matching their objective of providing performance that matches the VIX Index and function well as volatility hedges.

Spoiler alert. In this article I detail a portfolio strategy based upon the VIX index. The "theory" portion discussion is based upon the actual VIX index. There are significant performance differences between the actual VIX Index and the ETFs that are based upon it. Significant adjustments must be made when implementing the "theory" to account for the reality that the VIX ETFs have significant tracking error. Theories based upon the VIX Index may not translate into real world portfolio management due to the lack of available securities that accurately reflect its behavior.

Not to be deterred, however, I continued searching for a way to use a VIX ETF in a portfolio. The one thing that caught my eye about the VIX ETF is just how awful it was. It simply consistently lost money. I thought to myself that anything consistently that bad offers a great way to make money. The iPath S&P 500 VIX ETN (NYSEARCA:VXX) has never had an up year, never. Its graph demonstrates just how awful an investment the VXX has been. I'm not sure I've ever seen a chart so ugly. Clearly the VXX isn't an option for a buy and hold portfolio, at least not when the futures are in contango.

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My first thought was that this is the ideal short or put option candidate. While the fund does have periods of strength, it is only a matter of time before it returns to making new lows. While past performance is no guarantee of future results, how the VXX is created makes it very likely that the awful performance will continue.

To understand why the VXX is such an awful buy and hold investment, one has to understand how it is constructed. The VXX is based upon the VIX Index, a measure of market volatility. The key about the VIX Index is that it isn't a "trending" index, it is more like an electrocardiogram or EKG. Like the EKC the VIX Index has a baseline that it tends to "revert" to, and then occasionally spikes up from that level, only to return back to its base level after some time. The key is the VIX Index tends to return to a base level after a spike, it does not tend to trend higher over time. Most investments tend to "trend," so the VIX's behavior is rather unique for an investment.

Because of this flat and then short-term spike behavior based upon volatility, the VIX Index is the perfect passive hedge for a portfolio. Unfortunately, that EKG behavior simply is not able to be replicated in an ETF or ETN, or at least not yet. The reason the VIX Index is difficult to replicate is because of a situation that exists in the VIX Index Futures called "contango." This problem is so well known that iPath came out with the iPath S&P 500 Dynamic VIX (NYSEARCA:XVZ) to compensate for it. This chart demonstrates the performance difference between the VXX and the XVZ.

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While the XVZ may be an improvement over the VXX, it still does an awful job replicating the VIX Index.

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The reason contango is so disastrous when applied to the VIX Index is because the VIX Index doesn't trend, it spikes. When contango exists there is only 1 out of 4 ways to make money. Under a contango condition, future prices are above the cash price. That means that as time passes, the future price is guaranteed to fall by expiration, all else held equal. If you buy a future at 1500 and the index is 1000, as time passes the future will converge towards 1000, and at expiration trade at 1000 if the underlying index does not change in value from the time the future was purchased.

That means that under contango, if the index remains the same the future will lose money, if the index falls the future will lose money, if the index gains but not by enough to cover the contango spread the future will lose money. The only way to make money when a future is in contango is when the index rallies by more than the future cash spread that existed when the future was placed. In the above example, the index would need to rally from 1000 to over 1500 for that trade to make any money. The odds are simply skewed against making money when a future is in contango. Most months you simply are buying high and selling low.

Contango is bad enough, but contango on an EKG like Index is a nightmare. With a trending index, there is a possibility that the index will rally above the futures price that existed at purchase. The VIX however usually sits around 10 and 12, and then periodically spikes up to 20 or more, and then comes crashing back to between 10 and 12. The vast majority of the time the VIX is just sitting there waiting for volatility to perk up. The VIX is like a fire station where the firemen are usually doing non-fire fighting related jobs around the station, but then every once in a while the bell rings and everything springs to life. Once the fire is out, however, the fire fighters return to the routine of the fire station. The total amount of time a fire fighter will actually spend fighting fires over a career is relatively short, most time is spent on non-fire fighting duties. Making money on the long VIX is like trying to make money on when the fire fighters are away fighting fire. To me, you are much more likely to make money trying to figure out how to make money when the fire fighters are in the station, than when they are fighting fires.

Apply that concept to contango VIX futures and most of the time the contango premium will erode away with time, the VIX is at 10, the Future is purchased at 12, the VIX doesn't move, the future expires at 10 for a $2 loss. Assume the VIX is at 10, the 3 month VIX future is purchased at $12, the VIX immediately spikes to 20, but by expiration the VIX is back to 10. The trade still loses $2. With an EKG type index, there are very very few opportunities where a contango future will actually turn a profit. Even you are right you can be wrong. It would require the VIX to spike right before and hold the gains through expiration, something the price chart proves doesn't appear to happen too often.

This is a dated chart that shows how the long VIX ETF typically has a series of losing months, broken up by the occasional temporary spike, only to quickly return to losing money again. To me, figuring out how to turn those loss months into gains offers a better opportunity than trying to capture that one brief spike of positive returns.

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Clearly, if the VIX ETF is going to be used as a portfolio hedge or opportunistic/speculative trade, it is best used in a market timing model.

I'm not a big fan of market timing, so as I mentioned above, my first thought wasn't of the long VIX ETF as a tool to hedge or a volatility measure, my first thought was that this long VIX ETF was an ideal instrument to short or buy put options on. My thought was to forget what the VIX ETF is trying to be, that being a volatility hedge, and simply look at what it is. What it is is a consistent loser, at least it has been. I don't think I've ever seen a chart that screams "short me" more than the long VIX ETF.

That being said, I don't like shorting, especially naked shorting. I prefer to buy securities that do the shorting internally. Fortunately there is just such a security, the Pro-Funds Short S&P 500 VIX (NYSEARCA:SVXY). Instead of going long contango futures, it shorts them. That is a far better strategy to use when futures are in contango. Sell high, buy low is the strategy. Under the short contango strategy, when the VIX is at 10 and the future is at 12, you sell the future at 12 and buy it back at 10 if nothing changes, and you make a $2 profit. Unlike the long strategy where 3 out of the 4 options resulted in a loss, under the short strategy 3 out of the 4 options results in a gain. Those are the kinds of odds I like.

This graph of the long VIX and short VIX ETFs shows just how dramatic the performance difference is between the two. The short VIX ETF has a consistent uptrend, and the long VIX ETF has a consistent downtrend. What I like about those trends is that 1) they are highly uncorrelated with the market making them nice diversification holdings and 2) the contango situation provides a theoretical underpinning that allows for an understanding of the factors supporting the trend. I simply feel more confident in investing in something that I understand why it is doing what it is doing, and why I should expect it to continue doing what it is doing.

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Best of all, unlike the VXX which has never had an up year, the SVXY has never had a down year. Yes, it has a rather short life span, but the contango situation increases the probability that current trends will continue into the future. It is worth noting that its sister fund, the Velocity Shares Inverse VIX (NASDAQ:XIV) has a longer history and was down over 45% in 2011. Past performance of course is no guarantee of future returns, but contango helps understand why the past trend may continue into the future. Also, be sure to study the above chart. While it does have solid performance, the drawdowns can be sizable. This is still a very volatile holding, and should be used in buy and hold accounts with caution.

I finished writing this article and submitted it for publication on February 7, 2014. Coincidentally it looks like someone at the WSJ/Barron's has noticed the exact same concept. Yesterday morning (February 8) I discovered an article published the day before (on February 7) and I thus edited my original draft to include the following quote and a link to the article. One additional concept I gathered from this article is that the ratio of assets in the long versus the short VIX funds may provide a gauge of market sentiment. More money flowing into the long VIX fund would be bearish, more money flowing into the short VIX fund would be bullish.

Here's the background. The VXX has been a money furnace for five years. Launched shortly after the financial crisis as a means of owning volatility futures in an exchange-traded package, it has fallen an annualized 62% over five years. That's annualized, as in, falling an average of 62% a year....

The new asset leader, VelocityShares Daily Inverse VIX Short Term ETN (XIV), is a very different beast. This one delivers the opposite of VXX's index. So if the one seemingly falls and falls, shouldn't the other rise and rise? Most of the time, yes, it does. But matters are more complicated than that.

The VelocityShares ETN is sort of like a high-octane bet on market confidence. As long as investors aren't paying up for stock-market insurance, this one is likely to keep rising. As it has as it posted a three-year annualized return of 24%, well ahead of the S&P 500′s 13%.

In conclusion: In my opinion, the VIX ETFs are flawed volatility hedging tools, both the long and short VIX funds. They simply have too much tracking error versus the index. If they are to be used as hedging instruments they should be used with a market timing model that signals short-term trades, where the VIX ETF is purchased at critical times and held for a relatively short period of time. The long VIX fund in particular is not an option for a buy and hold portfolio, at least not when futures are in contango. It is best used in tactical portfolios, or a short or put option strategy candidate. It simply has a very high probability of generating a loss when futures are in contango.

What I think the best use of these VIX ETFs has nothing to do with market volatility. The chances of using the VIX ETFs to gain from sudden bursts of market volatility are far and few between, and requires accurate market timing. I think the best uses of these VIX ETFs are as diversification assets and tools to capitalize upon the unique market phenomenon called contango. When the markets are in a contango situation, buy the short VIX ETF. The contango situation skews the probability that the return will be positive. Unlike the long VIX ETF that continually loses money during non-volatile periods because of contango, the short VIX ETF should continually make money during non-volatile periods because of contango. Yes, there will be bouts of volatility that will disrupt that theory, but over the long run, the short VIX fund should do well as long as the futures are in contango. Periods of relative calm are simply more frequent and far longer than panics. Because of that, the VIX will spend much more time near 10 and 12, than 20 and 30. If the futures are in contango, that will skew the returns towards positive for the short VIX fund... at least in theory.

Disclaimer:This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. For my full disclaimer and disclosure, click here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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